Will fiat currencies survive?

Money that is entirely created by government fiat celebrated its 40th birthday this summer. Are the inflation hawks mad to think it might not survive the crisis?
John Llewellyn
4 October 2011

Economies beat to a slower rhythm than the real-time tickers that financial markets are inundated by. Every decade has its distinctive characteristics, and each serves to shape its successor. The 1950s were shaped by the re-integration of soldiers into civilian employment, reconstruction, and a more systematic management of demand. Exchange rates had been pegged. International trade grew rapidly. Public debt fell markedly. Economic growth got under way. The 1960s seemed a golden era. The OECD was formed amid optimism that a new US-led world of free movement of goods and capital would be better than the old one. Animal spirits were buoyant. OECD economies grew fast: 5.3% per year on average. But problems were building. With policy focused on demand management, OECD inflation doubled over the decade. And inflation differentials were causing currencies to become misaligned. Sterling had to be devalued in 1967, by a seemingly massive 14.3%.

The 1970s, saw matters come to a head. Differentials in international competitiveness had become so serious that, in 1971, the US suspended gold convertibility: the fixed exchange rate system was dead. In 1973-74, the price of oil quadrupled. Accommodating fiscal and monetary policies, in combination with wage indexation, took inflation into double digits. Deficits soared. Real interest rates became strongly negative. By the time of the second great oil shock, in 1978-79, policymakers had come to realise that they needed to reappraise their policies fundamentally: inflation control became the priority. Fiscal and monetary policies were tightened, the exact opposite of the earlier response. OECD growth slowed, averaging 3.7% per year.

The 1980s saw real interest rates and unemployment soaring, and output and inflation slowing. More fundamentally, they brought the realisation that OECD economies had a deeper problem: they had become rigid, unable to adjust efficiently to the changes in demand and production that the high price of energy required. Attention had to be paid not only to demand-side policies, but also to the supply-side. In 1982, under German exhortation, OECD countries began to see structural policies as the solution to supply-side rigidity. Liberalisation was on its way. But liberalisation went beyond the economic: Paul Volcker, the Fed chairman who had brought inflation down, was fired: anti-regulation Alan Greenspan was appointed. OECD growth slowed yet further, to 2.8%.

The product and labour market liberalisation begun in the 1980s proved constructive: it had been well thought through, and probably helped in the absorption of two shocks soon to hit: the IT revolution, and the rise of China. But financial liberalisation, by contrast, had not been anything like fully thought through.  The 1990s saw the institutionalising of inflation targeting. And inflation indeed continued to slow. Financial liberalisation and deregulation, however, gathered pace. Faith was placed, not least by chairman Greenspan, in the supposed ability of markets to self-regulate. Credit and leverage grew rapidly. Stock markets boomed. And the decade produced its share of crises: asset price busts in Japan and Nordic economies in the early 1990s, Europe's exchange rate mechanism in 1992; the Asian blow-ups of 1997; and the Russian default of 1998. OECD growth averaged 2.5% over the decade.

The 2000s saw matters come to a head. Financial innovation pushed on to the point where, for example, more than half the world's debt securities were being deemed "risk-free" by the ratings agencies. Inflation-targeting central banks not only disregarded asset-price inflation, but cut rates to support financial markets, such as after the dotcom bust in 2001. The rest, as they say, is history: history that in 2008 brought the largest crisis since the 1930s. OECD growth over the decade averaged just 1.7%.

The post-war decades certainly saw their share of crises: currency devaluations, sovereign defaults, major bouts of inflation, oil crises, equity and emerging market bubbles and blow-ups. But none compares with what is now unfolding: the only true comparison is with the 1930s.

The 2008 crisis has been wrongly characterised. The oft-used phrase  “Great Recession” creates the impression that the (western)  economy is following the contours of a typical recession, only more severe. But the economy is not in a typical recession: the real problem is the (comparatively rare one) of widespread over-borrowing. A  more accurate, if less reassuring, term, which owes to Professor Rogoff, is the “Second Great Contraction”. This correctly depicts the crisis as a typical deep financial crisis, not a typical deep recession; in which the term “contraction” applies not only to output and employment, but also to debt, credit, and leverage. The response – massive fiscal and monetary expansion – served to stave off the worst. But don't hold your breath. The evidence of the importance of the inherited past is that the West is in for a difficult decade.

Europe’s problems are intensifying

The euro area faces four conceptually distinct, albeit interrelated, issues (see Buiter (2011), Europe: Fear and Panic Make Poor Counsellors)

  1. Bank liquidity and solvency problems, of differing degrees of severity, through most of the euro area (and indeed in some non-euro-area EU members);
  2. A sovereign solvency crisis in the ‘narrow periphery’ (Greece, Ireland, Portugal);
  3. A sovereign liquidity crisis in the ‘broad periphery’ (Spain and Italy); and
  4. A possible downgrade in the ‘soft core’ (Belgium and France) and of the European Financial Stability Fund (EFSF).

The crisis will continue until the banking sector has been properly addressed. Europe has the wherewithal to support its banks, particularly once the EFSF enhancements come in. Sales of stakes in banks to foreign sovereign wealth funds are also an option. Ultimately a package can be put together for the ‘insolvent’, narrow periphery, consisting of:

  • Balanced budgets; and
  • Structural reforms; in return for
  • Debt restructuring (once the banks have been recapitalised)

The ECB has the requisite funds to stand behind the broad periphery, but it is reluctant to support Spain and Italy. However, until and unless the EFSF is made large enough, the ECB will need to perform this role. Otherwise, Europe will need outside help. Downgrades in the “soft core” are unlikely to be an insurmountable obstacle. France and Europe could probably live with them; after all, a €1tn double-A rated EFSF is far better than a €440bn triple-A rated one. But if confidence really takes a battering,  coordinated help from abroad may be required.

It is in the world’s interests for Europe’s crisis to be solved

If the euro area were to break apart, the political and economic consequences would likely be tumultuous; both for the whole of Europe, and well beyond. Therefore Europe will, in all probability, not be left to fend for itself. A euro area break-up is very much not in Asia’s (and especially China’s) interests, so these countries would likely be willing to help out: and they have the requisite resources. This would likely  be done under the agency of the IMF, at the request of the G20. It is highly likely that, in extremis, the outside world would save the union, if European politics stop Europe from getting its own house in order sufficiently quickly.

Longer-term sustainability requires a political solution: monetary union without (a more complete) fiscal union will always have potential for trouble. Europe – a collection of individual and individualistic nations – usually requires a crisis to reform. This crisis may well not be the last but, provided that political will remainsit seems likely that Europe will continue to advance, crisis-by-crisis, towards sustainability. To do this, the euro area needs to move towards closer fiscal union - the EFSF, and its permanent replacement, the ESM, are large steps in this direction.
Eurobonds are not the solution to the current crisis - they would likely require Treaty change, and so are not a near-term option: euro bonds are more likely to form part of the solution for longer-term sustainability, perhaps as far as a limited euro bond, of up to 60% of GDP. The so-called “Blue Bond” proposal (Jacques Delpla and Jakob von Weizsäcker, May 2010)  has a lot going for it (in terms of impact/moral hazard/political feasibility). But it will be difficult, and no doubt will require balanced budgets (and debt-to-GDP ratios far closer to 60%), real fiscal convergence, and significant surrender of fiscal sovereignty involving changes to the Lisbon treaty. Whatever Europe’s path, its economy is set for an extended period of pain.

The world’s problems do not end with Europe

Over the past half-century, at least one major economic area, most commonly the United States but sometimes Europe or Japan, was in a position to take up some of the slack in demand, thereby helping sagging economies elsewhere. Not so today: Greece, or Portugal, or Ireland are not islands of grief in an otherwise healthy world - much of the (advanced) world has major debt problems, and financial markets are increasingly demanding that these be reduced.

When Europe’s crisis is credibly on a path to being resolved – one way or the other – attention stands to turn to the US. At the start of the crisis, the US and Europe both had a banking crisis, and both had a serious fiscal problem. Both had to be fixed:. Europe started relatively quickly to address its fiscal crisis, but has been slow to face up to, let alone address, its banking problems. The US moved quickly to solve its banking crisis, but seems politically gridlocked over addressing its fiscal crisis.

The IMF is forecasting US public debt at 100% of GDP, significantly above the euro area figure  (89%). Moreover, the US fiscal deficit, at 10% of GDP, is more than twice that of the euro area (4%).

As if all that is not enough, it is possible that, in this environment, the world is starting to witness a potential loss of faith in fiat money. Since WWII, (advanced) economies have been pushed quite hard.   Unemployment has been low by historical standards, and capacity utilisation rates high.

Up until the early 1970s, currencies were backed (at least notionally) by something in relatively fixed supply (gold). In 1971, President Nixon suspended gold-convertibility, and the dollar became fully fiat currency. It was not necessary to be a gold nutter to wonder whether successive governments would be strong and resolute enough to keep aggregate claims on the economy broadly in line with the economy’s potential, and thereby not put undue pressure on inflation. Today, that question is being asked with growing intensity. Investors are fretting about the temptation for governments to try to inflate their way out of debt; even though this would likely be difficult, if not impossible.

This is not the only inflation issue. Over a run of years, politicians have made all manner of (implicit and explicit) promises that, even in the best of times, their economies would not have been able to deliver - particularly in respect of pensions, health-care, and education. In the slow-growth period ahead, the gap between promises and what is delivered will be all the greater. The risk is that in this weak demand, high-debt, over-promised environment, policymakers may achieve something they had not bargained for: high inflation; little or no growth; and/or disappointingly little reduction in public debt.

All this could increasingly undermine investors’ perception of currencies as reliable stores of value. Ex-Fed Chairman Volker wrote of the dangers of this course earlier this week. And former Fed Chairman Greenspan opined that:“What the price of gold is saying, is that there [are] elements within the marketplace that feel very uncomfortable with respect to what is going on generally…”

Fiat currencies celebrated their 40th birthday on 15 August 2011. By historical standards, the world has almost no experience with them. A question that some investors are asking is the extent to which fiat money is, or is likely to remain, an adequate store of value. Their discomfort may or may not be justified. But it is comprehensible. Their jitters may substantially be due to the fact that no-one truly knows how a fully fiat currency regime will play with the political stresses ahead. And the lack of credibility of governments makes the work of orderly resolution much harder, and risks making the concerns and discomforts of investors to a degree self-fulfilling.

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